Most home buyers do not have sufficient assets to purchase a home outright on a cash basis. Therefore, lenders such as banks and credit unions offer mortgage loans to potential home buyers. A mortgage is a legal document that pledges a property to the lender as security for the payment of a debt. If the borrower fails to repay the debt, the lender has a legal claim against the home which allows the lender to sell the property and use the proceeds to pay off the loan balance (foreclosure). The mortgage loan therefore allows the home buyers to purchase a home and pay for the home over time, while also ensuring that the lender is repaid.
In addition to offering loans to potential home buyers, lenders also offer such loans to existing home buyers for the purpose of refinancing. Refinancing refers to the process of paying off one loan with the proceeds from a new loan using the same property as security for the repayment obligation. For the borrower, the purpose of the refinancing is usually to obtain a lower interest rate and/or to obtain cash for other purposes by reducing equity in the home. Herein, loan funds used for “financing” housing includes both loan funds used for purchasing housing and loan funds used for refinancing housing.
Mortgages carry default risk to the lender that depends on a wide range of borrower, property and transaction characteristics. Relevant borrower characteristics include the purpose of the loan, credit score, income, employment longevity and financial assets. Relevant property characteristics include type of structure, appraised value and location. Relevant loan transaction characteristics include the type of mortgage, term, ratio of loan to property value, and method used to document the financial status of the borrower.
Lenders protect themselves against default risk in three ways. First, they assess every loan against underwriting requirements, which are complex rules designed to determine whether a particular set of borrower, property and transaction characteristics can be approved. Underwriting is primarily a “yes” or “no” decision process, though sometimes it can be conditional. Increasingly, underwriting has become automated, with human underwriters entering the process in doubtful or borderline cases.
The second way in which lenders protect themselves against risk is to require borrowers to purchase mortgage insurance. The prevailing rule is that borrowers are required to purchase mortgage insurance if their down payment on a home purchase, or their equity in a refinance, is less than 20%. In the event of a foreclosure, the mortgage insurer will pay to the lender the difference (up to the agreed-upon coverage amount) between the unpaid loan balance plus foreclosure expenses, and the net proceeds from the foreclosure sale.
The third and by far the most important way in which lenders protect themselves against risk is to adjust the interest rate, referred to as “risk-based pricing” or a “risk premium.” The adjustment takes the form of a rate increment above that charged on a “prime” transaction, which is one that carries the lowest risk. In a typical prime transaction: a) the borrower has a good credit history, including a FICO score of at least 720; b) the loan amount is 80% of property value or less; (c) the borrower has had stable employment for at least 2 years and fully documents income and assets; and (d) the property is a single-family home used as the borrower's primary residence.
As borrower, property and transactions characteristics diverge from those of a prime transaction, rate increments increase. The market uses a rough classification system in which loans fall into three categories: “mainstream”, “Alt-A” and “sub-prime”. Alt-A loans usually involve weak documentation while sub-prime loans involve low credit scores, though in both segments many other factors can be involved. In the mainstream segment, risk premiums can run up to 1.5-2%, in the Alt-A market they can get to 3%, and in the sub-prime market they can reach 5%.
In the mortgage insurance system, more than half of all insurance premium dollars are typically placed in a reserve account. In contrast, in the risk premium system, risk premiums that are not needed to cover current losses are realized as income by investors. As a result, they are not available to meet future losses. This makes the risk premium system vulnerable to a major episode of default, which episodes tend to occur about every 12-15 years.
Such an episode occurred in 2007-8, with devastating consequences on a world-wide basis. If even one-quarter of all of the risk premiums charged borrowers during the previous 10 years had been maintained in reserve accounts, all of the losses should have been amply covered. But reserves were not maintained and the losses severely depleted the capital of major financial institutions. Mortgage insurers, in contrast, while hard hit, had more sufficient reserves to cover their losses.
Portfolio lenders, who hold the mortgages they originate, do carry loan loss reserves, but the tax laws discourage significant contributions to these accounts. In any case, most loans are sold in the secondary market and end up as the collateral underlying mortgage-backed securities. Each individual security carries reserves, but there is no carryover from one security to another.
Every mortgage security carries “credit enhancement”, which are special protections for investors. One common form of credit enhancement, called “excess spread”, channels part of the risk premiums into a special reserve account which is available for meeting losses. However, at some point the funds in the account that are not needed to meet losses are paid out to investors who have purchased the right to them.
A cardinal principle of securitization is that each security must stand on its own bottom. For legal and operational reasons, reserves cannot be shifted between securities. Thus, even though the losses on securities issued during 2000-2004 were generally small, none of the funds in those reserve accounts have been available to meet losses on securities issued in 2006-2007, which were high.
The paradoxical result is that mortgage risk premiums are both too small and too large. They are too small to meet the losses from a bulge in defaults over a short period. But if risk premiums were properly reserved, the reserve accounts would be far larger than needed to meet even a major default shock. It would be advantageous to provide systems and methods which may enable lower costs to borrowers and minimize losses.